Secular Outlook Series

Tomorrow’s Europe

Our secular view is that the status quo is not an option for the eurozone. In the near term, we believe it is more likely than not that Greece will exit the eurozone.

While a Greek exit would likely be messy and volatile, our baseline view is that a smaller union will persist. To be sustainable, it will have to be underpinned by much stronger fiscal union, greater support for the banking system, and mutualization of debt to mitigate cross-border capital flight risks.

We think the ECB’s role will evolve somewhat over the next few years, and it is likely that the bank takes on more cross-border regulatory responsibilities.

These challenges in Europe are contributing to a blurring of lines between credit and interest rate risks, as well as between developed and emerging markets. We carefully consider exposure to those risks as well as seek to guard against confiscation risk and financial repression.

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What will Europe look like a year from now? Over the next few years? Longer?

Events in Europe are making global headlines every day. Taking a step back, European portfolio managers Andrew Balls, Mike Amey and Andrew Bosomworth assess the long-term outlook for both the U.K. and the world's largest economic zone, focusing on how political and monetary structures may change.

Q: What is the secular (three- to five-year) outlook for Europe and its monetary union?Balls: Our secular view is that the status quo is not an option for the eurozone: We cannot continue to muddle through for several more years. In the near term, we believe it is more likely than not that Greece will exit the eurozone. There is considerable uncertainty about the extent to which this crisis prompts policymakers to make difficult decisions, choosing between closer economic and political union of remaining countries or greater fragmentation and possibly even a complete dissolution of the eurozone.

Our baseline view is that while a Greek exit would likely be messy and volatile, a smaller union will persist, anchored by Germany, France, Italy and Spain. For this union to be sustainable, however, it will have to be underpinned by much stronger fiscal union, including fiscal institutions, as well as greater support for the banking system and mutualization of debt in Europe in some form to mitigate cross-border capital flight risks.

The big questions are: Precisely how will Europe forge the closer fiscal union, and what role is Germany willing to play? All the solutions of mutualization and closer union in Europe are founded on the sharing of Germany’s balance sheet, the strongest in Europe. Germany must play a leading role in several of the critical fiscal decisions.Q: How might German policymakers approach the formation of a smaller monetary union? And could you discuss the secular outlook for Germany’s economy?Bosomworth: Our secular outlook for Germany is reasonably positive because of the configuration of exports it sells – both within Europe and to the rest of the world – as well as its dominant economic and political role in Europe. However, Germany would benefit from nurturing domestic demand and relying less on external consumers.

Again, if Europe is to pursue a path toward greater federalism, then Germany must take the lead. Our view is that German political leaders are actually quite reluctant to do that, considering the history of the past several decades. They do not wish to be seen as the dominating power within Europe. On the other hand, complete fragmentation of the monetary union could severely weaken Germany, because termination of the euro and a return to legacy currencies would likely mean Germany’s new currency would appreciate, making its exports more costly.

Q: Turning to another leading economy, what is the secular outlook for the U.K.?Amey: The good news is that the U.K. has its own currency and is willing to use that currency flexibility to support growth during a period in which multiple sectors of the economy have to go through a protracted period of higher savings and lower borrowing – a scenario we find most likely over the secular horizon.

The challenge we face in the U.K. is that our largest trading partner, unfortunately, is Europe: About 50% of our exports go to Europe. So, the challenges of Europe are affecting the U.K. The financial system in the U.K. is still vulnerable, and complete fragmentation of the eurozone would likely have very severe consequences for the U.K.’s financial system and its growth outlook.

Q: What are the implications of eurozone fragmentation for both Europe and the global economy? What is the likelihood of a disorderly process?Balls: Perhaps the most important question in the secular outlook is how Europe will handle the likely exit of Greece from the eurozone and the implications of that exit. If Europe is unable to prevent a contamination of sovereign balance sheets and stem or control exits from the eurozone, then what has been a very difficult crisis over the past two years could reach new levels of disruption. Capital controls and banking support would be needed to prevent widespread bank failures. All financial markets in Europe would face currency risk. These potential adjustments are very, very difficult to quantify, but they are enormous.

One of the easiest things to say is that this would likely be an environment of no growth in Europe and, indeed, rolling recessions. This could trump the collapse of Lehman Brothers, with very significant global implications for trade, financial markets and banking systems as well as overall confidence. European fragmentation would come at a time of already weak growth in the U.S. and Japan, and slowing growth in emerging markets. This kind of big eurozone shock is not priced into global financial markets, in our opinion.

Q: Over the next three to five years, do you see the role of the European Central Bank (ECB) changing? Bosomworth: We think the ECB’s role will evolve somewhat over the next few years, depending on what occurs on the fiscal and political side of the equation. It is not going to change much in terms of its regular monetary policy operations, but in the context of Europe moving toward greater federal structure, it is likely – and is certainly desirable – that the bank takes on more cross-border regulatory responsibilities. Oversight responsibilities are currently decentralized at a national level.

Larger changes are likely to occur not with the central bank but with eurozone fiscal policy addressing the need for capital firewalls. A critical firewall could be the creation of pan-European bank deposit insurance. That would have to come from the fiscal authorities, since they would provide the guarantees that could stem public panic and bank failures.

Q: Do you see the Bank of England reversing policy over the next few years away from easing? Or does that depend on events in Europe?Amey: The Bank of England has signaled it intends to support economic growth and has been an extensive user of nonstandard emergency tools. We expect short-term real yields to stay comfortably in negative territory throughout the secular horizon, unless there is a very dark outcome for Europe and deflation risks become pronounced. Bank officials can tolerate higher-than-expected inflation as long as they retain a sufficient degree of credibility, and we think they will. So the theme of financial repression and negative real rates is likely here to stay for most of the secular horizon.

If the economy recovers, then as we move toward the end of the secular horizon, the Bank of England is likely to be faced with the difficult challenge of reversing policies. It is difficult to ascertain both how successful nonstandard tools might be or what the reaction of the economy would be to their removal. Our expectation, therefore, is that given the policy uncertainty around how the unwinding will work, that there will be a tendency to leave those nonstandard policy measures in place for longer than needed. Thus, toward the end of the secular horizon the balance of risk could move to slightly higher inflation.

Q: How should investors be thinking about and investing in Europe in their portfolios?Balls: We are focused on defending our clients against the risks of eurozone debt contamination, default and burden sharing. In our European portfolios, we look globally for exposure to strong sovereign balance sheets and solid growth, including high-quality emerging market exposures. And we suggest investors consider smarter global benchmarks that focus on a country’s contribution to global productivity (GDP) rather than the amount of debt outstanding (sovereign bond market capitalization) relative to other nations. Such an approach should help reduce or avoid exposure to weaker European sovereigns.

And as investors navigate the secular outlook, they may benefit from a focus on the nitty-gritty details of cash and collateral management, and more broadly, being prepared for adverse outcomes in the eurozone.

These challenges in Europe are contributing to a blurring of lines between credit and interest rate risks, as well as between so-called developed and emerging markets. As part of our global approach, we carefully consider exposure to interest rate and credit risks as well as seek to guard against confiscation risk and financial repression.

Amey: While also targeting exposures to strong balance sheets, within the U.K. respect the fact that real rates are likely to remain negative throughout much of the secular horizon but that longer-term inflation risks remain. For U.K. investors, that speaks to considering shorter-dated high quality nongovernment securities and longer-dated inflation-linked bonds.

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​Past performance is not a guarantee or a reliable indicator of future results. Investing in the bondmarket is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.